412(I) Plans and and the IRS audits and lawsuits.

Lance Wallach

 

412(i) is a provision of the tax code. A 412(i) plan is a defined pension plan. A 412(i) plan differs from other defined benefit pension plans in that it must be funded exclusively by the purchase of individual insurance products (insurance and annuities). It provides specific retirement benefits to participants once they reach retirement and must contain assets sufficient to pay those benefits. To create a 412(i) plan, there must be a plan to hold the assets. The employer funds the plan by making cash contributions to the plan, and the Code allows the employer to take a tax deduction in the amount of the contributions, i.e. the entire amount.

The plan uses the contributed funds to purchase some combination of insurance products (insurance or annuities) for the plan. As the plan participants retire, the plan will usually sell the policies for their present cash value and purchase annuities with the proceeds. The revenue stream from the annuities pays the specified retirement benefit to plan participants.

In the late 1990's brokers and promoters such as Kenneth Hartstein, Dennis Cunning, and others began selling 412(i) plans designed with policies created and sold through agents of Pacific Life, Hartford, Indianapolis life, and American General. These plans were sold or administered through companies such as Economic Concepts, Inc., Pension Professionals of America, Pension Strategies, L.L.C. and others.

These plans were very lucrative for the brokers, promoters, agents, and insurance companies. In addition to the costs associated with administering the plans, the policies of insurance had high commissions and high surrender charges.

These plans were often described as Pendulum Plans, or other similar names. In theory, the plans would work as follows. After the defined pension plan was set up, the plan would purchase a life insurance policy insuring the life of an individual. The plan would have no cash value (and high surrender charges) for 5 or more years. The Corporation would pay the premium on the policy and take a deduction for the entire amount. In year 5, when the policy had little or no cash value, the plan would transfer the policy to the individual, who would take it at a greatly reduced basis. Subsequently, the policy would bloom like a rose, and the individual would have a policy with significant cash value, which he or she could withdraw tax-free.

Who signed off on the plan?

Attorney Richard Smith at the law firm of Bryan Cave issued tax opinion letters opinion, which stated that many of the plans complied with the tax code.

So what is the problem?

In the early 2000s, IRS officials began questioning Richard Smith and others and giving speeches at benefits conferences wherein they took the position that these plans were in violation of both the letter and spirit of the Internal Revenue Code. When I spoke at the annual nation convention of the American Society of Pension Actuaries on problems the IRS chief actuary also spoke. The convention was in Oct. of 2002. The IRS chief actuary discussed how the IRS was looking at these plans. This was not the first notice of IRS looking at these plans as being abusive. Most in the industry knew that the IRS would be coming after the participants in these plans well before the convention. Insurance companies continued to push these plans in spite of the potential IRS problems. They had participants sign disclosures saying that they would get their own tax advice. The insurance company disclosures were fraudulent. The disclosures were fraudulent because they did not disclose the fact that the IRS was in the process of taking action against people that were buying the plans. The insurance companies had a duty to disclose this fact to the buyers of the plans and to the buyers of the insurance that went inside the plans. They knew that by getting buyers to sign the disclaimers, without disclosing the true facts, they would have a defense if the buyers tried to sue.

In February 2004, the IRS issued guidance on 412(i) and began the process of making plans "listed transactions." Taxpayers involved in listed transaction are required to report them to the IRS. These transactions are to be reported using a form 8886. The failure to file a form 8886 subjects individual to penalties of large addition fines for every year in the plan, even if no contributions are made. These penalties are often referred to as section 6707a penalties. Advisors of these plans are required to maintain records regarding these plans and turn them over to the IRS, upon demand. If the 8886 forms were not done properly it is as if the forms were not filed. You can do the forms after the fact, but most people then make mistakes on the forms, and the forms do not count.

In October of 2005, the IRS invited those who sponsored 412(i) plans that were treated as listed transactions to enter a settlement program in which the taxpayer would rescind the plan and pay the income taxes it would have paid had it not engaged in the plan, plus interest and reduced penalties. In late 2005, the IRS began obtaining information from advisors and actively auditing plans and more recently, levying section 6707 penalties.

If you were, or are still in a 412i plan time is of the essence. You have no statue of limitations if you did not, or do not properly file the 8886 forms. In addition to losing your tax deduction, you then get fined a minimum of $10,000 per year on the corporate level, and $5000 a year on the personal level.

I only know of two people who are skilled at doing the 8886 forms after the fact. I have received hundreds of phone calls from people who did the forms and still got the fines because the forms were not properly done.

 Lance Wallach, the National Society of Accountants Speaker of the Year, speaks and writes extensively about retirement plans, Circular 230 problems and tax reduction strategies. He speaks at more than 40 conventions annually, writes for over 50 publications, is quoted regularly in the press, and has written numerous best-selling AICPA books, including Avoiding Circular 230 Malpractice Traps and Common Abusive Business Hot Spots.  Contact him at 516.938.5007 or visit www.vebaplan.com.

                       

The information provided herein is not intended as legal, accounting, financial or any type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.